Economic Crisis Via Massive Consumer Debt

Two economists explain their hypothesis about the current economic crisis in today's WSJ:

The 2001 recession might have ended the [housing] bubble, but the Federal Reserve decided to pursue an unusually expansionary monetary policy in order to counteract the downturn. When the Fed increased liquidity, money naturally flowed to the fastest expanding sector. Both the Clinton and Bush administrations aggressively pursued the goal of expanding homeownership, so credit standards eroded. Lenders and the investment banks that securitized mortgages used rising home prices to justify loans to buyers with limited assets and income. Rating agencies accepted the hypothesis of ever rising home values, gave large portions of each security issue an investment-grade rating, and investors gobbled them up.

But housing expenditures in the U.S. and most of the developed world have historically taken about 30% of household income. If housing prices more than double in a seven-year period without a commensurate increase in income, eventually something has to give. When subprime lending, the interest-only adjustable-rate mortgage (ARM), and the negative-equity option ARM were no longer able to sustain the flow of new buyers, the inevitable crash could no longer be delayed.

The price decline started in 2006. Then policies designed to promote the American dream instead produced a nightmare. Trillions of dollars of mortgages, written to buyers with slender equity, started a wave of delinquencies and defaults. Borrowers' losses were limited to their small down payments; hence, the lion's share of the losses was transmitted into the financial system and it collapsed.

A few things to note: 1) the government loosened credit to those who shouldn't have received it, thus sowing the seeds for the credit swaps; 2) the Fed was too slow to recognize and thus respond to the problems that the Congressionally encouraged behavior caused; and 3) while bubbles occur in the market, they are usually self-correcting and don't inflict catastrophic damage on the greater economy when left to themselves (i.e., without government-sanctioned market manipulation). Yet, the lesson the left seems to have learned from this is to manipulate the market, like a kid who keeps touching a hot stove.

Whole piece in its wonky glory here.